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How to Value Stocks: Cash Flow-Based Valuations

Despite the fact that most individual investors are ignorant of cash flow, it is probably the most common measurement used by investment bankers for valuing public and private companies. Cash flow is literally the cash that flows through a company during the course of a quarter or the year after taking out all fixed expenses. Cash flow is normally defined as earnings before interest, taxes, depreciation, and amortization (EBITDA).

Why look at earnings before interest, taxes, depreciation, and amortization? Interest income and expense, as well as taxes, are all tossed aside because cash flow is designed to focus on the operating business and not secondary costs or profits. Taxes especially depend on the vagaries of the laws in a given year and actually can cause dramatic fluctuations in earnings power. For instance, early in a company's life, it usually loses money. When the company starts to turn a profit, it can often use those losses from previous years to cut its taxes. That can overstate current earnings and understate its forward earnings, masking the company's real operating situation. Thus, a canny analyst would use the growth rate of earnings before interest and taxes (EBIT) instead of net income in order to evaluate the company's growth. EBIT is also adjusted for any one-time charges or benefits.

As for depreciation and amortization, these are called non-cash charges, as the company is not actually spending any money on them. Rather, depreciation is an accounting convention for tax purposes that allows companies to get a break on capital expenditures as plant and equipment ages and becomes less useful. Amortization normally comes in when a company acquires another company at a premium to its shareholder equity -- a number that it accounts for on its balance sheet as goodwill and is forced to amortize over a set period of time, according to generally accepted accounting principles (GAAP). When looking at a company's operating cash flow, it makes sense to toss aside accounting conventions that might mask cash strength.

When and how to use cash flowCash flow is most commonly used to value industries that involve tremendous up-front capital expenditures and companies that have large amortization burdens. Cable TV companies, for instance, reported negative earnings for years as they made huge capital expenditures to build their cable networks. However, their cash flow actually grew; huge depreciation and amortization charges masked the companies' ability to generate cash. Sophisticated buyers of these properties use cash flow as one way of pricing an acquisition, thus it makes sense for investors to use it as well.

The most common valuation application of EBITDA, the discounted cash flow, is a rather complicated spreadsheet exercise that defies simple explanation. Economic value added (EVA) is another sophisticated modification of cash flow that looks at the cost of capital and the incremental return above that cost as a way of separating businesses that truly generate cash from ones that just eat it up.

The most straightforward way for an individual investor to use cash flow is to understand how cash flow multiples work. By looking at recent mergers and acquisitions, you can divide the price that the acquirer pays for a company by its cash flow, producing a price-to-cash flow multiple. Then you can compare that ratio to the multiple of the company you're looking at.

Investors interested in going to the next level with EBITDA and looking at discounted cash flow or EVA are encouraged to check out the bookstore or the library. Since companies making acquisitions use these methods, it makes sense for investors to familiarize themselves with the logic behind them as this might enable a Foolish investor to spot a bargain before someone else.

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